Fed Unleashes Gold

The Federal Reserve shocked the financial world this week, defying
universal expectations. It failed to start reducing the pace of its third quantitative-easing
campaign's debt monetizations, delaying the long-anticipated QE3 taper indefinitely.
This surprise ignited sharp moves in nearly all major markets, but gold's was
certainly the most impressive. It rocketed higher on the Fed's startling new
paradigm shift.

All year long, gold has been plagued by fears of the Fed tapering QE3. Starting
with the January 3rd release of the minutes from the December FOMC meeting
(where QE3 was more than doubled to include direct Treasury monetizations),
QE3-tapering fears have dominated the gold markets. Futures traders
in particular have been pathologically obsessed with the QE3 taper, ignoring
everything else that affects gold.

Every major gold selloff this year, which has been the worst by far in gold's secular
bull, began with either an FOMC decision or the subsequent release of
the minutes from those meetings. Last week I wrote an
essay detailing QE3-tapering fears' brutal impact on the gold price in
2013. Futures traders hammered it down an astounding 28.3% at worst this
year on their belief that the Fed would start tapering QE3 this week.

But after plummeting from about $1675 as 2012 ended to $1200 in late June,
the whole premise of that selloff just vanished Wednesday! After months
of setting market expectations for the QE3 taper, Ben Bernanke's Fed unexpectedly
aborted. A perfect opportunity to start tapering, with the stock markets near
record highs so they could easily absorb any resulting selling, was spectacularly
squandered by the Fed.

Many times this year I'd argued that the Fed couldn't exit QE3. When
it slowed and ultimately stopped buying long-term Treasuries, long interest
rates would climb as the dominating buyer exited the market. The resulting
higher long rates would collapse the fragile housing recovery and send US unemployment
surging higher again. Thanks to Obama's stupendous debt growth, they'd even sink
the US government.

But like nearly everyone else, I bought into the universal expectations that
the Fed would start a modest QE3 taper this week. I certainly didn't believe
QE3 would be fully phased out by the middle of next year as most thought, but
I couldn't imagine the Fed taking the huge credibility hit by not tapering.
One thing Bernanke's Fed has been pretty adept at is ensuring its actions meet
prevailing market expectations.

The Fed not tapering QE3 this week changes everything. The FOMC holds
8 meetings per year, but only after every other one does the Chairman hold
a press conference where he can explain the FOMC's thinking. There are only
2 meetings left in 2013, October 30th and December 18th. The next one has no
press conference, and there is insufficient economic data between now and then
to see improvement.

The FOMC chose not to taper QE3 this week because it "decided to await more
evidence that progress will be sustained" in "economic activity and labor market
conditions". There's only one more critical monthly US jobs report before the
FOMC's next meeting, September's in early October. And after the very weak
August jobs report earlier this month, even a great next jobs report isn't
enough data for a trend.

That leaves the December FOMC meeting for a taper, the next one with a Bernanke
press conference. But that is really problematic, as is the subsequent January
29th meeting, because of Ben Bernanke's retirement on January 31st. How to
proceed with QE3 is a decision best left to the next Fed Chairman so close
to the end of Bernanke's reign, and she (it will likely be uber-dove Janet
Yellen) won't start until February.

The first FOMC meeting under the new Fed leadership is actually March 19th.
So even if US economic data improves dramatically, and even if the levitating
stock markets somehow magically manage to avoid correcting sharply, Bernanke's
decision not to taper QE3 likely added at least 6 months to its lifespan!
To minimize bond-market carnage, QE3 still has to be tapered gradually no matter
when that process starts.

The implications of this are staggering, especially for gold. When
the Fed buys bonds, it creates the money to do so out of thin air. Quantitative
easing is just a pleasant-sounding euphemism for debt monetization.
And when it buys Treasuries in particular, the wildly-overspending Obama Administration
immediately injects these new dollars into the economy. The result is QE is
pure high-octane inflation.

This first chart is updated from last week, showing the size and composition
of the Fed's balance sheet (the bonds it has purchased). Across it are noted
the dates of key FOMC meetings over the past 5 years or so when major policy
changes were made. Despite Fed officials endlessly talking about ending QE
since 2009, the record shows the Fed has done just the opposite. QE
just grew and grew and grew.

The Fed's balance sheet has grown massively in the QE3 era, up a whopping
29.2% in the year since QE3 was born! That is $818b worth of bonds purchased,
a staggering amount of new money created out of thin air in a single year.
Indeed as of the end of August, QE3's $40b per month of mortgage-backed-bond
buying and $45b per month of Treasury buying added up to $800b. September is
adding another $85b.

QE2 only had $600b of new buying, and that was so inflationary that the gold
price surged 24.7% higher over its span. As I outlined last
week, Bernanke laid out his best-case (fastest) scenario for QE3 tapering
in mid-June. It proposed starting the taper later this year and ending QE3
entirely by mid-2014. If you run the math on this, it would have grown QE3
by another $383b or so, taking its total over a whopping $1250b.

But if this week's stunning QE3-taper delay indeed costs 6 months due to the
big Fed transition and near certainty of the long
overdue major stock-market correction, QE3 is going to be vastly bigger
than most had imagined. Tapering still has to be gradual to minimize
bond-market disruptions, so that additional $383b of QE3 over the 9 months
of tapering is almost certainly still baked in. Add in 6 full months on top
of that!

$85b a month between October and March is another $510b, before the $383b
over 9 more months when QE3 is eventually tapered off. That adds up to $893b,
which doubles the $885b of bonds already monetized as of the end of
this month! Bernanke's dithering may have just ballooned QE3's ultimate size
from around $1250b to over $1750b. That would make it as large as QE1,
the biggest QE campaign ever.

But even that understates the magnitude of the newly-elongated QE3. QE1 only
included $300b of direct Treasury monetizations, the purest form of inflation.
Remember that Washington nearly instantly spends all the newly-created money
the Fed sends it to buy its bonds. These dollars are immediately injected into
the real economy in the form of government spending. QE2 only had $600b of new Treasury
buying.

Assuming that QE3 tapering now isn't announced until the March meeting, the
first under the new Fed Chairman, today's $45b per month of Treasury buying
will have run 15 months. That takes it to $675b. A subsequent gradual 9-month
taper would add another $200b or so. Thus the Treasury portion alone of QE3
now has real potential to ultimately grow to $875b. That is nearly as big as
QE1 and QE2 combined!

There was only one dissenting member on the FOMC this week (Esther George),
and the reason she voted against the decision not to taper QE3 was she "was
concerned that the continued high level of monetary accommodation increased
the risks of future economic and financial imbalances and, over time, could
cause an increase in long-term inflation expectations." She is absolutely right
of course.

As the Fed continues to dump vast amounts of brand-new fiat dollars into the
economy, relatively more money will be competing for relatively less goods
and services. With the US economy growing at 2% if we are lucky, yet the Fed's
balance sheet mushrooming 29%, monetary growth is radically outpacing the growth
in things to spend it on. This guarantees rising prices, which feed
on themselves psychologically.

The more prices rise, the more investors pay attention to them and start worrying
about them. This creates the dreaded "inflation expectations", which the Fed
has been fighting for decades. Because people's behavior changes dramatically
when they come to expect persistent high inflation, the Fed has always been
terrified at this prospect. Part of this manifests in a vast flood of investment
capital migrating into gold.

During the lifespans of QE1 and QE2, gold powered higher by 50.8% and 24.7%
respectively. Yet as of the day before this week's FOMC decision, it was down 24.4%
so far during QE3. This stunning anomaly is absurdly illogical, and can't persist.
With QE3 suddenly shaping up to be the largest Treasury monetization ever,
is there any chance gold's
QE3 anomaly will last? Not a snowball's in hell I suspect.

The day before QE3 was born last September, before the Fed bought $818b of
bonds, gold was trading near $1733. I think the surest bet in all the markets
today is that gold will be much higher when QE3 ends than it was before
QE3 was born. Since gold has lost so much ground, that means an epically massive
gold upleg is imminent. In fact it has already begun, gold has advanced much
since its late-June lows.

Gold's extraordinary weakness this year was indeed related to QE3, but only
indirectly. As stock traders basked in the Bernanke Put, the Fed having their
backs, they drove an extraordinary stock-market levitation in 2013. This led
to a self-reinforcing mass exodus from the global flagship GLD gold ETF, weighing
heavily on gold prices. Thankfully that unsustainable trend already
started reversing in August.

As the heavy differential selling pressure on GLD forced its custodians to
liquidate its holdings, major gold support levels were breached. This ignited
unprecedented futures
forced liquidations that caused gold to plummet. This led to another huge
anomaly that has already started to unwind as well. This next chart looks at
the excessively-low long positions and excessively-high short positions held
by futures traders.

Once a week the Commodity Futures Trading Commission details the futures positions
held by three major groups of traders in its famous Commitments of Traders
reports. This chart, which I explained
in depth in July, shows futures speculators' (both large and small) total
long and short positions held in gold futures. The continuing mean reversions
from recent excesses will drive the next stage of gold's young upleg.

Thanks to the extraordinary QE3-driven stock-market levitation, 2013 was an
extraordinarily anomalous year. One of the main reasons gold fell so precipitously
was because futures speculators sold fantastic amounts of long and short contracts.
You can see the huge divergences this year from the 2009-to-2012 average levels
of total spec longs and shorts in gold futures. This is wildly unprecedented
in this bull.

The yellow line on the right adds up the total deviations each week in 2013
in spec longs and shorts from their normal averages of the preceding four years.
As I told our subscribers back in June and July, the gargantuan short positions guaranteed a
new gold upleg would be born. And it was. Highly-leveraged futures contracts
have expiration dates, so traders who borrow to sell short soon have to
buy to pay back.

At worst in early July, the total deviation from norms of these long and short
positions ballooned to 204.1k contracts! Each futures contract controls 100
troy ounces of gold, so this represented 20.4m ozs or 634.8 metric tons of
gold that futures traders had to buy in the coming months merely to revert
to normal levels of longs and shorts. That dwarfed even the 444.0t of gold
liquidated during GLD's wildly-unprecedented exodus.

As of the latest CoT report current to last Tuesday's close, this deviation
from norms was still way up at 142.9k contracts of gold futures. Speculators
still had to buy on the long side and buy to cover on the short side the equivalent
of 14.3m ozs of gold, or 444.5t. This means that fully 70% of the absolutely-inevitable
mean reversion in speculators' gold-futures positions is still yet to come,
which is wildly bullish.

The initial 30% drove gold 18.2% higher by late August, a massive $218 rally
from this metal's brutal late-June lows driven by futures traders' fears of
QE3 tapering. The remaining 2/3rds of this futures specs' mean reversion is
likely to triple this total rally to $650 or so off the lows, more than
erasing all of gold's losses in 2013. This week's stunning Fed decision will
likely accelerate that necessary futures buying.

All year long futures traders operated under the critical assumption that
the Fed would soon start slowing and then end QE3. They somehow managed to
ignore the Fed's balance sheet swelling by nearly a third in a year, they were
so fixated on the idea of QE ending soon. But now it's not. The Fed either
can't or won't start withdrawing QE3 anytime soon, which is going to ignite
serious inflation expectations universally.

Motivating futures traders and normal investors even more, the levitating
stock markets are overdue to roll over into a major correction (a serious selloff
approaching 20%). The FOMC decision this week is going to accelerate that.
The knee-jerk reaction to no tapering pushed the S&P 500 to another new nominal
record high, which extended the span since the end of the stock markets'
last correction to nearly 24 months.

On average healthy stock-market cyclical bulls experience major corrections once
a year or so. The FOMC itself may prove the initial selling catalyst
for the next one. By not tapering this week, the Fed sent the signal that
the US economy isn't anywhere near as strong as euphoric stock traders believed.
Not tapering QE3 with expectations so high for it to happen was a big vote
of no confidence in the US economic recovery.

So it looks like the Fed has really unleashed gold with this shocking decision
to continue QE3's massive debt monetizations at full strength indefinitely.
The day of that FOMC meeting this metal rocketed from around $1297 early in
the day to $1364 by the time the US stock markets closed, up $67! Gold's
biggest up day since just after 2008's stock panic (after which it more than
doubled) is a huge bullish harbinger.

Markets don't move in one direction forever, and a massive reversal is already
underway in gold and imminent in the general stock markets. Sadly mainstream
traders are too mired in groupthink to see this, they continue to foolishly
believe gold will fall forever while the stock markets rise forever. But the
Fed's stunning decision this week will greatly accelerate the demise of oversold
gold and overbought stocks.

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The bottom line is the Fed's inaction on QE3 this week changed everything.
Contrary to futures traders' expectations which hammered gold all year long,
we remain firmly entrenched in the quantitative-easing era. And as all throughout
world history, any central bank creating vast amounts of money out of thin
air to "finance" its own government's overspending is highly inflationary.
Gold soars in inflationary times.

The big uncertainty the Fed injected into the mix is going to stoke inflationary
expectations like nothing else could. Whenever Fed officials start talking
about slowing QE3 again, fewer traders are going to believe them since their
credibility is shot. As more and more speculators and investors come to understand
the reality of QE3 being extremely inflationary, capital is going to increasingly
flood back into gold.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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